Now What?

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Is it an insignificant crack, or a sign that the foundation is about to crumble? That's what Pepco Holdings found itself wondering when one of the 16 participants in its revolving-loan syndicate recently exercised an option to reduce its exposure by 20 percent.

Any threat to its credit line triggers alarm at Pepco. The $1.5 billion revolver provides liquidity for the electric utility's unregulated businesses, which have commodity price exposures and mark-to-market collateral activity, says CFO Paul Barry.

"We had heard of several banks dropping out of credit facilities altogether, so we are fortunate. But the surprise is that only one bank has come to us asking to [offset] some of its exposure," says Barry. "A number of banks are under pressure to do it."

While investment-grade Pepco has largely evaded fallout from the subprime crunch, CFOs at other companies may see lines of credit shrink or even vanish as more banks scramble to buttress teetering capital structures. In response, Pepco has heightened its credit monitoring of financial institutions. "We want to know our exposure to them as a trading partner, especially with volatile commodity prices," Barry says. "We have limited or stopped trading with those that pose a significant risk."

Changes that only marginally disrupt solid borrowers such as Pepco may be more keenly felt in transportation, retail, financial, and other distressed sectors, where routine refinancing arrangements are history. United Airlines, RadioShack, and Radian Group, for example, have gone to unusual lengths in recent months to tailor revolvers or find substitute lenders willing to extend credit lines.

"It's the worst credit environment I've seen, and I've been with the company 18 years," says Bob Quint, CFO of Radian, a $1.3 billion bond insurer. Last April, ahead of a credit downgrade, Radian renegotiated the ratings covenant out of its revolving facility. A less than accommodating bank group cut the commitment size by 37 percent, to $250 million, secured it with Radian assets, and slightly shortened the term. The group also charged an amendment fee of $1.9 million. "For now, we will live with the reduced size of the facility," Quint says. Radian shifted some funds from its financial-guaranty business to its mortgage-insurance business to cover a shortfall.

In this dicey climate, CFOs face tough questions about revolving credit lines. Are they safe? When the time comes to renegotiate, will borrowers have enough clout to secure a newline on similar terms? The answers pose serious implications for day-to-day operations and long-term growth.

Bad Feelings

At banks with huge mortgage losses and write-offs, idle commercial lines of credit are shrinking — but not because companies are borrowing more. According to the Federal Reserve, Wachovia Corp.'s unused commercial-credit commitments to U.S. companies dipped to $151 billion in the second quarter, 10 percent less than a year earlier. Merrill Lynch's commercial bank reports that unused lines dropped by 25 percent, to $31.3 billion, while Cleveland-based National City reports a modest 7 percent pullback in corporate lines of credit, to $20.5 billion.

Data from Reuters Loan Pricing Corp. shows that revolver issuance to companies was tepid in the first half of 2008 — just $288.2 billion, almost 50 percent less than in the first half of 2007. "If banks are feeling bad about life, they start chopping unused lines wherever they can," warns Christopher Whalen, managing director of Institutional Risk Analytics, a firm that monitors bank safety and soundness.

Tremors can be felt far beyond commercial banks. Other financing sources, including institutional investors, show scarce interest in standing behind corporate lines of credit. For borrowers, says David Casper, executive managing director of BMO Capital Markets, "the world has gotten a lot smaller in the last six months."

As pivotal cogs in the corporate credit growth engine, institutional investors have no need to back revolvers with low fees on large commitments. "Investors don't want in-and-out activity," says Steven Bavaria, a managing director in leveraged finance at rating agency DBRS. "They want to get their interest coupon every three months and have the money outstanding earning a return." Even in good times, says Mike McAdams of Los Angeles–based Four Corners Capital Management, many investors participated in revolvers only to stay on line for term loans.

Before financial institutions can even extend credit lines to corporate customers, they must tend to their debt. Together with seven of their money-center peers, Bank of America, Citigroup, and JPMorgan Chase must refinance $247 billion of bonds maturing between October and March 2009, according to Dealogic. Worse, as of September, nearly one in five banks stood on the verge of credit downgrades by Standard & Poor's, up from 9 percent in similar straits a year ago.

Rising demand and weaker credit spell one sure outcome: more-expensive debt for lenders and borrowers. Bankers' borrowing spreads have already doubled since early January, to 377 points over LIBOR and 105 points more than the tab for investment-grade nonfinancials.

The ripple effect on Main Street is clear, says BMO Capital's Casper: "If a bank has to raise money at 8 percent, it can't lend at 6 percent."

Managing Down

Even capital-constrained banks cannot simply yank lines of credit without repercussions, says consultant John Walenta, a partner in corporate banking at Oliver Wyman. But they can seek modifications, especially if a company is close to violating a covenant. If a bank is already committed, the focus may shift to "just managing down the size of the line," Walenta says, especially if a borrower rarely uses more than a fraction of the balance. Banks may not pull credit lines overnight, but "they will say, 'Our relationship with you on this particular facility is coming up for renewal — find yourself another bank,'" says Bob Graves, co-chair of the banking and finance practice at Jones Day. "Banks' credit committees are getting much more finicky."

Hampered by restrictions on its line of credit, troubled UAL, parent of United Airlines, often won concessions by demanding them. But recently it had to dangle an exceptional offer in front of lenders to temporarily ease a restrictive covenant. The company paid a 7 percent fee ($109 million) so earnings could at times slip below fixed charges without triggering technical default.

Wary borrowers now fear lenders won't be able to renew facilities when they mature. In August, RadioShack issued $325 million in convertible unsecured notes to replace a revolver terminating in June 2009, which it uses for working capital. While RadioShack will pay a lower rate of interest (2.5 percent), it can't redeem the notes prior to maturity, and the holders can force the company to buy the notes back on a material adverse change. What's more, $40 million of the proceeds go to hedge against dilution to the company's common stock when the notes convert to shares.

Middle-market companies and small businesses have less leverage when it comes to protecting their credit lifelines. With these customers, a line of credit more often is simply a demand note. "Absent lenders liability, a bank always had the contractual right to reduce or eliminate a line of credit as it saw fit," says Robert J. Pruger, finance chief at Rudolph/Libbe Cos., a commercial builder with a $27 million revolver.

Banks simply don't make money on credit lines, and may even lose money if the credit lines are a substitute for more-productive loans. Returns increase only when amounts are drawn, when banks also issue a term loan, or when opening a line leads to sales of other profitable services to the customer, like cash management. As a remedy, banks have tried to raise fees for unused credit lines above a typical 25 basis points, but fierce competition has often stymied those efforts.

"[Lines of credit] are attractive to us in the context of a broader relationship," says Todd Morgano, a spokesman for National City. "We are moving forward with less emphasis being placed on stand-alone credit."

With bad news surrounding banks, regulators are digging into commercial lending on several levels. They want to know more about the nature of those loans and underlying assets to "detect weaknesses in asset quality that may result from slowing economic conditions and to ensure appropriate risk-management practices," Donald Kohn, a Fed vice chairman, said during a Senate hearing in June. Regulators are particularly interested in the condition of large syndicated credits shared by three or more banks, as well as underwriting practices for leveraged loans, Kohn said.

That can affect credit lines, says attorney Tom Vartanian, a partner at Fried, Frank, Harris, Shriver & Jacobson LLP and a former general counsel for the Federal Home Loan Bank Board. More scrutiny puts a damper on lending and, by extension, credit. "When a financial institution is hunkering down and regulators are evaluating its risk, capital, and management," says Vartanian, "it fundamentally means there are fewer funds available at the margins."

Accounting-rule changes could lower an even weightier boom, not least by forcing wider recognition of credit lines on lenders' balance sheets. Imminent changes to the Basel II accord, which set standards for how much regulatory capital banks set aside, could off set an expected reduction in capital needed to support commercial loans. The Basel II committee has recommended that by January 2010, banks treat trading and banking portfolios alike, so that both encompass risks related to defaults, liquidity, credit and equity spreads, and changes in credit ratings.

So far the committee has not directly addressed liquidity risk stemming from undrawn commercial lines of credit. Agreement exists, however, that they represent a significant threat to liquidity in the banking system. A recent CFO survey found that 43 percent of U.S. companies and 59 percent of European companies have not drawn down any portion of their lines.

"How does a banking organization come up with the liquidity if there is suddenly a massive run to the bank to draw on those lines?" asks Bert Ely, an independent banking consultant. "We need to factor this more explicitly into the capital requirements of banks — that feeds back into pricing." That could boost the cost of credit lines, Ely says. The good news for companies? "The Basel process is slow and cumbersome."

Banks alleviate pressure on their balance sheets by selling loans to other investors, but offloading lines of credit defeats the goal of eventually booking profitable loans. If banks want to adjust the business model by initiating lines of credit and then handing them to other lenders (somewhat like origination fees for home mortgages) that's another matter, but fees would likely be razor-thin. Moreover, if activity in the market for investment-grade loans (which plummeted 66 percent in the first half of 2008, according to Reuters Loan Pricing Corp.) is any indication, there would be few if any buyers.

A sliver of good news awaits credit-hungry CFOs. By historic standards, loans are very cheap, says Four Corners's McAdams, whose firm structures fixed-income investments. That could entice buyers. And if inflation goes on a rampage, it could draw investors seeking a buffer against interest-rate hikes, because loans are floating-rate products. "They can pick up spread" without going further out on the yield curve, he explains.

Enduring the Irony

But good returns for investors mean the loan market is pricey for issuers. Double-B credits were paying spreads of 300 to 400 basis points in late summer, on top of original issue discounts — pricing below par that increases the return. Hudson Products, a B-credit manufacturer of air coolers and fans, had to sweeten its loan deal twice in August, eventually offering a discounted yield of LIBOR plus 623 basis points.

To maintain fluid credit lines, CFOs should strengthen their relationships with well-capitalized banks while keeping an eye on banks' balance sheets. Credit ratings alone tell an incomplete story: watch the same dashboard that regulators and counterparties use to gauge a bank's creditworthiness. Robust metrics, say experts, include loan-to-deposit and loan-to-funding ratios as well as a bank's allowance for loan losses — measured against total loans and against nonperforming assets.

While there is certainly some irony in having to gauge the credit of a lender from which you want credit, BMO Capital Markets's Casper says it is simply a sign of these troubled times. As one CFO he knows put it, "I now realize I'm a better credit risk than the guys lending money to me."

Cash counts for a lot today, but tomorrow's bottom line depends on credit. "You may have strategies, but what about credit?" the treasurer of a West Coast shipping company asks. "In planning, credit now becomes the dominant piece."